Cash Flow Statement

Introduction to Cash Flow Statement, Objectives and Limitations

Objective

After going through this lesson, you shall be able to understand the following concepts.

Meaning of Cash Flow Statement Objectives of Cash Flow Statement Uses of Cash Flow Statement Limitations of Cash Flow Statement Some Important Terms Used in Cash Flow Statement

Meaning of Cash Flow Statement

Every business organisation needs sufficient cash for smooth working of normal business operations. Some of the normal business activities are cash payments to suppliers, payments of rent, wages, salaries, interest, etc. Besides these there are various day-to-day expenses that a business organisation has to meet such as freight, commission, etc. On the other hand, a business organisation also receives cash in form of payments received from sale of goods and services, cash received from debtors, repayment of loan by outsiders, interest on loan given to other institutions, debentures of other organisations, etc. Thus, we can say that there exists a continuos flow of cash into the business and a simultaneous flow of cash out of the business. The flow of cash into in a business is termed as cash inflows and flow of cash from the business is termed as cash outflows.

Cash Flow Statement records the inflows and outflows of cash and cash equivalents during a particular period. This statement is prepared to know how the cash and cash equivalents are used in the business. All the Listed Companies are compulsorily required to prepare the Cash Flow Statement as per the Revised Accounting Standard- 3 (AS-3) along with their Financial Statements. According to the AS-3, Cash Flow Statement is bifurcated into three main heads.

Cash Flow from Operating Activities Cash Flow from Investing Activities Cash Flow from Financing Activities

Objectives of Cash Flow Statement

The important objectives for preparing Cash Flow Statement are as follows.

The foremost objective to prepare Cash Flow Statement is to ascertain gross inflows and outflows of cash and cash equivalents from various activities of a business. Secondly, this statement helps in analysing various reasons responsible for change in the balances of cash and cash equivalents during an accounting year. This statement also helps the accounting users (such as creditors and the investors) to analyse and interpret the financial vitality and solvency of a company. Lastly, it facilitates the financial managers to ascertain the requirement and availability of cash in the near future.

 

Uses or Advantages of Cash Flow Statement

The important advantages of Cash Flow Statement are enlisted below. 

Short-term Financial Planning- This statement is very advantageous for short-term financial planning. It helps in assessing and forecasting the sources and utilisation of cash and cash equivalents during a particular period. Reasons for Change in Cash Position- It is possible that sometimes a company may have surplus cash even in case of lower profits or deficiency of cash in spite of higher profits. In such a situation, Cash Flow Statement helps in analysing the reason for the such change in the balances of cash and cash equivalents. Liquidity and Solvency Position- Cash Flow Statement helps in determining and assessing the liquidity and solvency position of the firm. Trend of Cash Receipts and Payments- This statement enables analysing and studying the trends of cash receipts and payments from various activities of a company. This in turn, helps the management in drafting various policy measures and short-term plans. Segregation of Cash Flows- As this statement segregates the cash flows from the various activities viz. operating activities, investing activities and financing activities, so it becomes very easy to identify cash flows from each activities separately. Dividend Decision- The Cash Flow Statement also reveals the position of cash (cash balance) with an enterprise at the end of a particular period. This helps the enterprise to take decisions regarding the payment of dividend with reference to the availability of cash. Comparative Study- This statement enables to conduct a meaningful comparison of previous years' cash flows with the anticipated cash flows of the current year. This helps in putting various cost controlling measures and checks in case of deviation from the planned targets.

Limitations of Cash Flow Statement

After going through the advantages and uses of Cash Flow Statement, we know that this statement is an useful tool for analysing financial position, but it lacks on the following fronts. 

Ignores Accrual Concept- As the Cash Flow Statement is prepared on the cash basis, so it ignores accrual concept. That is, transactions are taken into consideration only when the settlement takes place.  that This statement records the transactions only when settlement takes place. Ignores Non-Cash Transactions- Cash flow statement records only cash inflows and cash outflows. In other words, it does not records the non-cash transactions such as issue of bonus shares, conversion debenture into shares, etc. This fact limits this statement to reveal the true financial position of an enterprise. Non-Substitute of Income Statement- As stated in the above point that Cash Flow Statement considers on the cash transactions, however, Income Statements reveal both that is cash as well as non-cash transactions. Thus, Cash Flow Statement cannot be regarded as a substitute of Income Statements, thereby, does not represent the net income of a business. Complementary in Nature- Cash Flow Statement is complementary in nature in a sense that it has limited use in isolation without the financial statements. This is to say that it adds value to the financial statements but on its own, it is incomplete and fails to reveals the financial picture holistically.   Fails to Reveal True Liquidity Position- The true and actual liquidity position of an organisation cannot be judged merely by the Cash Flow Statement. This is because this statement reveals only the cash position of a business, while ignoring the assets such as fixed assets and current assets. Think of a situation, where all the assets of a business are sold, then there will be high cash inflows (because of  sale proceeds) and the Cash Flow Statement will indicate favourable conditions, but ironically this is not the situation!!

Some Important Terms Used in Cash Flow Statement

Cash- It consists of cash in hand and demand deposits with banks. Cash Equivalents- These are short-term highly liquid investments that are easily convertible into cash and which are subject to an insignificant risk of change in value. In other words, cash equivalents are held for the purpose of meeting short-term cash commitments rather than for investment or any other purpose. An investment held for short-term maturity say three months, can be regarded as cash equivalent. Some example of cash equivalents are treasury bills, commercial papers, etc. Cash Flows- Cash flows refer to the movement of cash in and out of the business. Cash flows can be either inflows or outflows of cash and cash equivalents. A cash inflow implies receipt of cash by the business and cash outflow implies the payment of cash by the business. Cash inflows result in increase in the total cash balance and cash outflows result in decrease in the total cash balance. Operating Activities- These activities are the main or principal revenue generating activities (such as sale and purchase of goods and services) of an organisation. Investing Activities- These activities basically involve sale and purchase of long-term investments and fixed assets. Long-term assets are the assets which are not meant for resale and are used for comparatively long period of time. Financing Activities- These are the activities which result due to changes in the composition and size of the capital structure and borrowings of an organisation.

Exercise

Read each of the following transaction carefully and sate with reason whether the transaction would (a) Increase, (b) Decrease or (c) No change in Cash and Cash Equivalents.

Cash Rs 20,000 deposited into bank Depreciation on Machinery Rs 5,000 Treasury bill Rs 3,000 matured Payment of Rs 15,000 made to supplies of goods Interest Rs 200 received on Investment Dividend Rs 3,000 declared and paid Profit of Rs 3,000 on sale of investment Loss on sale of Machinery Rs 1,600 Bill Receivable Rs 1,200 honored at maturity Debtors Rs 600 proved bad.

Solution

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